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LONDON (Reuters) - The failure of U.N. climate talks to clarify the future of the Kyoto Protocol and its market-based mechanisms could dry up investment in the carbon offset market, possibly threatening prices that are already trading near record lows.
A legally binding pact is unlikely to be agreed at the climate summit in Durban, South Africa, which starts November 28, as governments continue to wrangle over emissions cut commitments and climate aid. Many do not see such a deal emerging until 2014 or 2015.
Yet market participants say climate negotiators must send a strong message about the continuation of the 1997 Kyoto pact's market-based mechanisms or risk a further flight of investment.
"Parties must take the opportunity in Durban to send strong signals to the carbon market regarding their commitment to its continuation and future development," said Jose Tumkaya, chief operating officer at UK emissions-reduction project developer Ecosecurities, a JP Morgan-owned firm.
"Negotiators should be concerned about the historic low carbon prices as they do reflect, to some degree, a lack of confidence in the long-term commitment to existing emission reduction targets, as well as continued uncertainty with regards to a future international agreement," he said.
Kyoto binds 37 industrialized nations to cut greenhouse gas emissions by 5.2 percent below 1990 levels from 2008-2012. The gases covered by the protocol are believed to be speeding up the warming of the planet, causing severe floods and drought and threatening the existence of many small island nations.
Many developing countries like the Kyoto pact, because its Clean Development Mechanism (CDM) allows companies in rich countries to offset their emissions by investing in emissions-reduction projects in the developing world.
But primary investment in the CDM fell to $1.5 billion in 2010 from $2.7 billion in 2009 and $6.5 billion in 2008.
Benchmark U.N. carbon credits traded at a record low of 6.69 euros ($9.48) early this month on concerns about the future of Kyoto, slowing global growth prospects, record CDM credit issuance this year and stricter limits for using credits in the European Union's emissions trading scheme after 2012. [nL5E7LE1L0]
"The market broadly is expecting the CDM to continue, although we do not expect that clarity will be provided about its future in Durban," said Trevor Sikorski, director of carbon markets research at Barclays Capital in London.
Like most climate change negotiations, the forthcoming climate talks in Durban are likely to "have very little immediate impact" on market prices, he said, noting the market has largely priced in the view that little progress will be made.
The CDM's executive board has expressed concerns about the contraction of the carbon offset market.
"The board views this development with great concern as there is today a considerable risk of losing the private sector engagement and momentum in the mitigation of climate change that the CDM has thus far been instrumental in generating," it said in a draft annual report ahead of the Durban talks.
The board, as well as project developers, hopes the slowdown in primary CDM investment can be reversed with a new pact that succeeds the Kyoto Protocol and has tougher climate ambitions.
"Without an agreement, new investment in CDM is going to be rare, and there is not much private money that will be going into the market," said Gareth Phillips, chief climate change officer at UK firm Sindicatum Sustainable Resources.
The EU is the main buyer of CDM credits, and European leaders have agreed the region's $120 billion carbon market will continue until 2020. It will also back a Kyoto extension, if other major emitters commit to stronger emissions reductions.
"We can build the bridge to the future through a second commitment period. But that only makes sense if countries representing 85 percent (of global emissions) are willing to commit in the near future," said EU commissioner for climate action, Connie Hedegaard.
Russia, Japan, Canada and others will not sign up to a second commitment period unless it includes all major emitters.
China, India and others refuse to take on binding targets after 2012 unless all developed nations, including the United States, which never ratified Kyoto, not only sign up to a new pact but make much deeper emission cuts than already pledged.
Legally, Kyoto will continue unless governments agree to put it to rest. The pact will be toothless, however, without new and deeper emission reduction targets to ensure warming is contained to at least 2 degrees Celsius.
Yvo de Boer, the former U.N. climate chief, said governments could take a series of decisions in Durban to extend the Kyoto Protocol's mechanisms -- a move that would attract more private sector investment into cleaner technologies.
But some investors in emissions offsets say the best way to rescue the market is to move away from the protocol.
"If the major aim of Kyoto was to reduce global emissions, then it obviously has taken us in the wrong direction," said Russel Mills, global director for energy and climate policy at Dow Chemical Co.
Dow prefers a climate agreement that covers all major emitting nations, he said.
"That has to remain the one goal that we can't give up on, and there is a real risk of losing focus in Durban if we get involved in all kinds of complicated political fixes related to Kyoto," Mills added. ($1 = 0.705 Euros)
Reporting by Jeff Coelho; additional reporting by Nina Chestney, editing by Jane Baird